American Express Has an Edge on Peers

WE ARE INITIATING COVERAGE of American Express with an Overweight rating and a $53 target price.

American Express
(ticker: AXP) operates a unique mix of card-processing and lending businesses that are positioned to take advantage of the fallout from changes in the card landscape.

American Express' "closed loop" model and premium products, premium customers and premium pricing drive superior economics. Returns on equity in the high 20s reflect the strength of American Express' brand and network strategies, despite external pressures on most card issuers.

A focus on spending versus lending helped American Express rebound post-crisis and should drive outsized, long-term growth. American Express is on a clearer revenue growth trajectory sooner than its peers, due to its emphasis on payments-related fee revenue (83% of revenue) versus the typical card-issuer model that relies more heavily on net interest income.

American Express is positioned to take shareholder-friendly capital actions – targeting payout of about 50%, including a dividend of approximately 20%. Given targeted Tier 1 capital of 10% (versus 10.7% currently), American Express has roughly $1 billion to $1.6 billion of excess capital currently available for share repurchases or smaller-scale acquisitions over the coming quarters.

While the challenges of regulatory reform create uncertainty for American Express and other card companies, we believe American Express is best positioned. We see American Express' charge-card product as uniquely suited for consumers' recent "pay-as-you-go" approach to card usage. Also, American Express' rewards model continues to stand out among competing efforts to add value for households and merchants alike.

We believe American Express is attractively valued, given its expected higher growth and returns than other card issuers. American Express is currently trading at less than 12 times our 2011 earnings-per-share estimate of $3.50, which reflects an approximate one third discount to its historical (pre-crisis) average price/earnings of 19 times. In light of expected ROEs of about 27% going forward, we believe a P/E of 15 times is more appropriate. Accordingly, our target price reflects a 15 times P/E on our 2011 earnings-per-share estimate, or $53.

American Express sports leading products and brand for higher-end card users, giving it premium pricing with both consumers and merchant clients. Its focus on affluent customers has helped drive a faster-than-peer recovery in credit quality and spending over the past year.

The charge-card product is right for the times, in our view. We believe consumer trends toward deleveraging and expected higher-regulatory capital requirements make revolver-based lending models more difficult. American Express' pay-in-full charge cards, with attractive spend-based rewards incentives, should continue to gain mind share among consumers.

Credit-quality trends continue to be a tailwind for American Express. We see further improvement in loan delinquencies and net charge-offs over the balance of 2010, which should help fund investment in future growth. American Express has poured more of the benefits of excess reserves into marketing and promotion than other card issuers, providing a jump on the competition, as customer acquisition efforts will likely heat up over the next year.

American Express benefits from the secular shift in spending away from checks and cash toward more convenient forms of payment. Spending on cards comprises half of all spending today, and card-spending growth outpaces that of checks and cash by four to five times.

We expect spending growth, which has recently rebounded sharply off first-half 2009 lows, to level off in second-half 2010 and to expand at about 6% and 5% in 2011 and 2012, respectively.

Increases in affluent spending, mostly by existing customers, should drive American Express' billings growth in the near term. Over the longer term, we expect growth to reflect a combination of new cards in force growth (estimated 4.9%) and spending per-card growth (estimated 20% by year-end 2012).

The recent pullback in American Express' shares, due mainly to concerns about the economy, present to us an attractive buying opportunity. American Express currently trades at under 12 times our estimated 2011 EPS of $3.50, which should be roughly equal to "normalized" results.

American Express remains exposed to macroeconomic uncertainty, which could slow further credit improvement and cause spending levels to languish. Weak employment and income levels suggests a prolonged period of gradual recovery from last year's recession, which could cause American Express to temporarily fall short of its long-term goals of 8% annual revenue growth and 10% to 12% annual EPS growth.

New rules and regulations targeted at credit-card-issuing practices should dampen American Express' and other issuers' card lending-related revenue. The full brunt of the Credit Card Accountability, Responsibility and Disclosure Act has yet to be felt by the industry, and the act's pricing and fee restrictions will likely cause American Express' lending margins to return to historically average levels of about 9%.

Regulatory reform legislation that passed in July includes the planned creation of a Consumer Financial Protection Bureau (CFPB), which could put greater regulatory burdens and constraints on American Express' businesses. While presumably all consumer lenders will face similar regulatory pressures, American Express' premium pricing model could attract additional unwanted attention.

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